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3 We explain the methodology of the TED function by considering an example with a two year US Treasury, the 3% Treasury maturing in November Initially the user types CT2 <GOVT> TED<GO>. Once this is done one we arrive at the TED function screen. This screen includes input parameters such as bond price, face amount, settlement date and the different TED spreads as over-rideable fields. One can also specify what type of futures contract one would want to use as well as specifying the rates for the stub contract and the individual eurodollar futures. Once the different parameters have been set, the screen will match up the cash flows of the Treasury bond and the eurodollar contract. To do this, Bloomberg takes in the date of the first cashflow of the Treasury from the settlement date of the trade and finds the futures contract which this cashflow coincides with. We illustrate this calculation with Figure 1 which is the TED screen, and Figure 2, the CSHF function which shows the cashflows of the Treasury bond. 3

4 Figure 1 4

5 Figure 2 To calculate the TED spread one must match up the cash flows of the Treasury bond with the eurodollar futures contracts whose expiry coincides with the dates of the coupon payments. Figure 2 shows the Bloomberg CSHF screen which displays the future cashflows of the bond given a settlement date. This shows that the bond settles on 26 December 2002 and at this value date there are two more cashflows remaining. These are the coupon payment on May 31 st 2003 and the final coupon and principal payments on 30 November To calculate the TED spread we see that we need to use a total of 4 Eurodollar futures contracts. These are the EDZ2 <commodity> to EDU3<Commodity> contracts (we note here the Bloomberg tickers for these contracts). These Eurodollar futures are displayed on the lower half of the TED screen along with their rates or price, which option is selected by the user. 5

6 Calculation methodology The first step in calculating the Implied Yield TED is to calculate the interpolated discount factors derived from the eurodollar futures shown in figure 3. LAST PRICE RATE FUT_DLV_DT_FIRST FUT_ROLL_DT INT_RATE_FUT_END_DT STUB(EDZ2 COMDTY) Dec Dec Mar-13 EDH3 COMDTY Mar Dec Jun-03 EDM3 COMDTY Jun Jun Sep-03 EDU3 COMDTY Sep Sep Dec-03 Figure 3 For the 31 st May cash-flow we will need to use EDZ2 <comdty> to calculate the March 20 th discount factor; and the EDH3 <comdty> to calculate the discount factor for the expiry date 18 th June The stub period, which is the days to the expiry of the first contract, is (from settlement date of 26 December 2002) worked out as 84 days. Hence the discount factor for 20 th March 2003 is given by: (1+((1.4025/100)*(83/360)))^-1 = [1] To calculate the discount factor from the settlement date to 18 June 2003 we need to create a strip by multiplying [1] with the discount factor associated with the EDH3 <comdty> contract. This is the contract that begins on 17 th March and expires on 18 th June. A similar process is applied, namely: (1+((1.355/100)*(91/360)))^-1 = [2] Multiplying [1] and [2] will give the stripped discount factor for 18 th June, which is [3] Taking the log of [3] will give Now that we have the discount factors for the boundary dates, we can calculate the interpolated discount factor for 31 st May. Taking the natural logarithm of equation [1] will give a value of Taking the log of [3] will give us

7 Using ( ) + ((75/91)* ( )-( )) = and exp( ) = , we obtain the interpolated discount factor for 31 st May. This we label as [4]. A similar procedure is applied to calculate the discount factor for 30 th November Using EDM3 <commodity>, EDU3 <comdty> and the strips calculated in equation [3], we can calculate the discount factors for 17 September 2002 as , which we label as [5]. The corresponding discount factor for 17 December 2002 is [6] Using the same interpolation method used above we can calculate an interpolated discount factor for 30 th November 2003 as [7] As the bond pays a semiannual coupon equivalent of 1.5%, we then use the equation Future Value x discount factor = Present Value. Hence we have the present vale of the cash-flow on the 31 st May as ( ) * (1.5%) = [8] and that for 30 th November is ( ) * (101.5%) = [9]. The implied price of the Treasury bond is given by FV x DF - (accrued interest) which is equal to: ( ) = This gives the implied street convention yield as 1.474%. [10] 7

9 Figure 4 Portfolio TED spread analysis To apply the analysis for a portfolio of securities, we input the ticker of each security as well as their positions. This is carried out on screen PRTU<GO>, which set up a portfolio from scratch. Fixed income asset managers who wish to hedge their Treasuries with Eurodollar futures may create a portfolio of Treasuries and then type PTED<GO> 1<GO> to generate the report. Once the report is completed, PTED will display the total number of each of the eurodollar futures needed to complete a total hedge of the whole portfolio, the number of contracts needed for a specific treasury (as shown in figure 5), and the individual number of eurodollar futures needed to hedge a specific treasury security. 9

10 Figure 5 Conclusion Analysing the TED spread between a fixed income instrument and eurodollar futures allows market practitioners to hedge a specific treasury against future changes in interest rates, or to hedge a portfolio. TED analysis can also be used to speculate between the difference in yield changes between the yield on a fixed income instrument and London interbank rates. This becomes an accessible approach to hedging and speculation for TED trades on Treasuries which have longer maturities than 3 months, when the problem of matching cashflows becomes more pronounced. 10

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